Friday, December 21, 2012

On the state of macroeconomics: fashion versus logic and evidence

Yes there is something rotten in the kingdom of Denmark, and it is macroeconomics; pretty much as in every other country. There has been an ongoing debate on the blogosphere on the topic (see Krugman, Smith, Thoma, Williamson and Wren-Lewis, not in chronological order, by the way). The New Classical versus New Keynesian debate tends to be on two issues the relevance of microfoundations on the theoretical level, and the importance of price rigidities on the empirical side.

Scientists, as Mankiw put it, are the New Classicals that emphasize the microfundations. They have intertemporal maximization models based on rational representative agents. The New Keynesians are the engineers, again using Mankiw's dichotomy, that strive for economic realism. Or so is what you are expected to believe if you read their posts. Of course all of these presumptions are bogus.

Noah Smith correctly points out that they all use the same DSGE models. But Krugman notes that on policy debates the whole difference is based on the assumption of sticky prices. So they use the same models, but reach very different conclusions. Of course the tools are not neutral though. Using DSGE models has hurt the positions that New Keynesian want to take. For example, Krugman has been forced to argue that the reason for the poor recovery is that the natural rate of interest is negative (and hence the current rate is too high to bring investment and savings into equilibrium).

This is a much weaker position than the one taken by heterodox authors that suggest that the crisis is due to lack of demand associated to worsening income distribution over the last three decades, and the consequent expansion of unsustainable private debt to allow for consumption. So the poor recovery is associated to lack of demand, since wages are stagnant and private debt cannot increase (and the GOP is bent in not allowing public demand to grow).

Note that the Godley type models, which follow the heterodox perspective, were much better for understanding and foreseeing the crisis (see here). There is no reason for intertemporal maximization models, and their kind of microeconomics (Sraffians have better stuff for that). New Classicals, Mankiw notwithstanding, are not scientists (or at least not good ones), since their models do have significant logical problems, and you cannot be a good engineer, somebody concerned with practical applications of scientific knowledge, if you share a model that is flawed.

On an interesting note, Krugman's main complain about Noah Smith's position is that he doesn't understand that the New Classicals have basically treated New Keynesians as outcasts. In his words:

"the freshwater [New Classical] types simply didn’t accept the legitimacy of what the New Keynesians were doing — in fact, didn’t even bother to read any of it, because anyone who actually worked with that kind of model would know that fiscal policy can indeed have an effect in that framework."

The problem is that they don't think he is legitimate. In fact, that is true. Williamson says:

"It doesn't surprise me that Paul Krugman isn't up on what is going on in macroeconomic research. Why should we expect him to go to macro conferences, spend time in seminars, and talk to his colleagues at Princeton? He has plenty on his plate, what with delivering two NYT columns per week, blogging, talking to pundits, and giving speeches. But if he's not up on the field, what purpose does it serve to make up outlandish stuff for people to read?"

Indeed Williamson's critique is that Krugman is not up to date, on the cutting edge, Colander would say. So he has missed the last fashion season in macroeconomics. And Wren-Lewis makes a point that he is a Karl Lagerfeld of macroeconomics (not sure if that is a correct fashion quote). Wren-Lewis points out that:

PK [yes, Paul Krugman] was very much at the forefront of analysing the Zero Lower Bound problem, before that problem hit most of the world. While many point to Mike Woodford’s Jackson Hole paper as being the intellectual inspiration behind recent changes at the Fed, the technical analysis can be found in Eggertsson and Woodford, 2003. That paper’s introduction first mentions Keynes, and then Krugman’s 1998 paper on Japan. Subsequently we have Eggertsson and Krugman (2010), which is part of a flourishing research programme that adds ‘financial frictions’ into the New Keynesian model. You would not think of suggesting that PK is out of touch unless you are in effect dismissing or marginalising this whole line of research.

So he is pretty much au courant, according to his New Keynesian friends (and that sounds right to me too, by the way). No fashion problem with Krugman and New Keynesians. They are trendy too. Good for them.

Yet, what it is expected of science is not fashion, but relevance following logic and evidence. And yes Krugman is right, there is evidence for price rigidity, and also no evidence for the sort of theory of distribution implicit in the mainstream neoclassical DSGE models (productivity equals remuneration of factors of production), or for a natural rate for that matter. And that is the problem with Krugman and his New Keynesian friends, too much preoccupation with fashion, not enough with logic and evidence. If the profession remains concerned with fashionable models it will continue to be irrelevant and impractical.

8 comments:

Watching Krugman can be beyond bizarre sometimes. Recently he put forward a fairly decent point about the US not being Greece because they issue their own currency (where have I heard that before, hmmm?). Fine. But then he claimed to have a model to prove it.

I think "Hmmm... that might be interesting...". But then I read it. It's just a Mundell-Fleming model and then Krugman nakedly states that the Fed can control the interest rate. What was the point of the model? There was no point. None. Krugman could have made his argument in a sentence, but instead works through an ISLM-BP model and inserts his argument toward the end. Is this the best that the profession has to offer? Really?

Yep, it is bizarre, but the schizophrenia comes from the need to use conventional models. It's difficult to make reasonable arguments with crazy models. But mind you, Krugman says that was what reasonable people were trying to do in the 1980s. His words: “By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable." Link here http://nakedkeynesianism.blogspot.com/2011/09/if-youre-surprised-that-means-that-you.html

That's totally true. And I respect them (in some sense) for it. But if Krugman and his ilk are perfectly self-conscious about what I just described above then the profession has become so cynical that you'd have to just ask: is it even worthwhile?

My impression is that they're not conscious of what they're doing. And when they do stuff like what I just mentioned they think they're actually engaged in some sort of science. That's freaking weird.

I tend to agree that believe in neoclassical economics requires a willful ignorance about the facts, and it is hard to think that Krugman really believes that our problem is a negative natural rate of interest. And yes this is a very strange profession. Keynes wanted us to look more like dentists, which he assumed were dispassionate technicians. And Colander suggested that our standards are lower than garbage collectors.

It's not even the facts in this regard, Matias. It's that Krugman doesn't seem aware what argument he's making. His argument is very simple: the Fed controls the interest rate in the US therefore we are not Greece. But he feels the need to go through a whole Mundell-Fleming model to make this point when in fact the MF model is completely superfluous and he just slips in the controlled interest rate argument at the end of the discussion/soliloquy/meditation. Why does he need to do this? I don't know. I don't understand it. It's weird.

It reminds me of a scholastic in the medieval ages wanting to say something fairly simple and rational. But, in order to do so, they first feel the need to expound on whatever metaphysical system is popular at the time. So, in order to make a simple statement like: "Black cats are more popular in London" the scholastic has to go through all this stuff about what it means to have the "essence" of "catness" and how catness was distributed through the Great Chain of Being by our Lord and Savior... and so on. After this long disquisition -- so well parodied by playwrights and authors later on -- they would finally come out and make their simple statement on black cats in London. Pure ritual.